What Really Triggered the EM Rout? Here Are the Theories

(Bloomberg) -- The selloff in emerging markets that began three weeks ago caught investors off guard, and left many perplexed about the causes.

The rout hit all asset classes in developing nations and reversed their gains for the year. Local-currency debt has fallen almost 5 percent since April 19, and stocks and Eurobonds have lost about 3 percent.

While losses to Treasuries spooked investors -- especially as 10-year yields in the U.S. approached and then rose above 3 percent for the first time in more than four years -- that had been happening since September. Geopolitical tensions between Washington and Iran and Russia, as well as Donald Trump’s rhetoric threatening trade penalties against China, were nothing new, either.

“There is no one easy answer for the recent emerging-market selloff,” said Eric Stein, Boston-based co-director of global income at Eaton Vance Corp., which manages $430 billion of investments. “Investors are trying to figure out if these really are idiosyncratic or if there’s something more there.”

Here are some theories as to why it happened and whether it will continue:

Stronger Dollar

Analysts from Bank of America Corp. to Goldman Sachs Group Inc. have blamed the strengthening greenback for investors suddenly turning bearish toward riskier assets. Mid-April was the moment when traders were faced with not just climbing Treasury rates, but a sharply rising U.S. currency too, a situation they hadn’t experienced since 2016.

If the dollar and Treasuries were the primary trigger, emerging-market bulls had better hope that Jamie Dimon, JPMorgan Chase & Co.’s chief executive officer, and Michael Hasenstab, Franklin Templeton’s fixed income chief, are wrong. They both said Tuesday that U.S. 10-year rates are headed toward 4 percent.

Increasing debt sales to fund a widening government deficit and the Federal Reserve’s paring of its balance sheet are “a perfect storm for putting upward pressure” on U.S. yields, Hasenstab said.

Too Much Exuberance

Investors poured money into emerging markets in the two years through January, fueling a juggernaut that seemed all but unstoppable. As funds paid higher and higher prices for stocks and bonds in bid to escape historically low yields in developed nations, they stretched asset valuations. Spreads of local- and hard-currency emerging bonds fell to record lows of barely 200 basis points over Treasuries this year, around half the levels of early 2014.

“The main EM catalyst was positioning,” Morgan Stanley analysts including James Lord and Chetan Ahya, said in a note this week. “Real money investors came into the second quarter with overweight positioning. Once the dollar started to rally and U.S.-Treasury yields backed up, they had little choice but to reduce risk.”

Geopolitics and Trade

Russian assets sank in early April after the U.S. imposed new sanctions against companies and oligarchs seen as close to President Vladimir Putin. That reverberated across some other emerging markets, with traders wondering which businesses or countries the White House might target next. It also came shortly after Trump imposed tariffs on steel and aluminum imports, causing analysts to speculate whether China would retaliate.

But concerns about both issues soon eased as the White House toned down talk of a trade war with China and said it might relax Russian sanctions. That’s led banks including BofA and Standard Chartered Plc to say such tensions probably won’t knock developing-nation assets in the medium- to long-term.

Of greater concern is Trump’s decision to exit the Iranian nuclear accord, which has caused more volatility in energy prices and heightened fears of conflict between Tehran and Israel.

While the trade threats have been “all posturing” so far, the situation over Iran “is spooking people for more legitimate reasons,” said Tim Atwill, Seattle-based head of investment strategy at Parametric Portfolio Associates, which has around $13 billion of funds in emerging markets. “There are a lot of concerns in the Middle East. A risk that was contained doesn’t seem as contained any more.”

Local factors

Analysts have played this down, pointing to robust growth and low inflation in emerging markets as a whole, and saying they are much-better protected against external shocks than during the taper tantrum five years ago.

Two exceptions are Turkey and Argentina, whose currencies are the worst-performing among their peers this year thanks to high inflation and widening current-account deficits. Argentina went some way to appeasing investors, however, when it hiked its key interest rate to 40 percent last week and pledged to reduce spending.

©2018 Bloomberg L.P.

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